A covered expatriate is a U.S. citizen or long-term resident who meets specific criteria when relinquishing their citizenship or residency, resulting in significant federal tax obligations, including the exit tax. This article explains the definition of a covered expatriate, the tax implications, and key differences from non-covered expatriates. Whether you’re considering expatriation or need clarity on your tax responsibilities, this guide provides the essential details.
Who Is a Covered Expatriate?
A covered expatriate is an individual who meets specific criteria under U.S. tax law when relinquishing their U.S. citizenship or terminating lawful permanent resident status (green card). This classification carries significant federal tax obligations, including potential liability for the expatriation tax under Section 877A of the Internal Revenue Code. Individuals must certify their tax compliance with U.S. tax obligations over the past five years to avoid being classified as covered expatriates, which could subject them to exit tax liabilities.
Criteria for Covered Expatriate Status
To be classified as a covered expatriate, an individual must meet any of the following three tests at their date of expatriation:
- Average Annual Net Income Tax Test: The individual has an average annual net income tax liability exceeding a specified threshold over the five tax years preceding expatriation. For 2024, this threshold is $190,000.
- Net Worth Test: The individual’s net worth, including worldwide assets and certain deferred compensation items, is $2 million or more at the time of expatriation.
- Certification Test: The individual fails to certify on Form 8854 that they have complied with all U.S. tax filing requirements and tax obligations for the five tax years before expatriation. This includes filing all tax returns and reporting obligations. There are specific covered expatriate exceptions for certain individuals, such as minors and dual citizens, who may not be classified as covered expatriates even if they meet other criteria.
Net Worth Test and Fair Market Value
The net worth test is a crucial aspect of determining whether an individual is a covered expatriate. To meet this test, an individual’s net worth must be $2 million or more on the date of expatriation. The net worth is calculated based on the fair market value of their worldwide assets. Fair market value is defined as the price that a willing buyer would pay for an asset in an arm’s-length transaction.
In determining the net worth of an individual, all assets, including those held in trusts, must be taken into account. This includes assets such as:
- Real estate
- Stocks and bonds
- Mutual funds
- Retirement accounts
- Life insurance policies
- Business interests
- Art and collectibles
The fair market value of these assets must be determined using a reasonable method, such as an appraisal or a valuation by a qualified professional. It is important to note that the net worth test is applied separately to each individual, so if a couple is expatriating, each spouse’s net worth must be calculated independently. This ensures that each person’s financial situation is accurately assessed for tax purposes.
Exit Tax Implications of Covered Expatriate Status
Covered expatriates are subject to the exit tax, which operates under a mark-to-market regime. Under this rule:
- They are treated as if they sold (a deemed sale) all their worldwide assets at their fair market value the day before expatriation, triggering capital gains tax on any unrealized gains.
- Certain assets, such as tax-deferred accounts or deferred compensation, may be subject to additional rules or taxation.
- The exclusion amount for capital gains in 2024 is $821,000, reducing the taxable gain for some individuals.
The exit tax calculation is based on the deemed sale of worldwide assets, highlighting specific exemptions and complexities involved.
Additionally, covered expatriates must file Form 8854 with the Internal Revenue Service (IRS) to ensure compliance with expatriation provisions and report their deemed sale calculations and tax liabilities.
Exceptions to Covered Expatriate Status
Some individuals are automatically excluded from being covered expatriates if they meet specific conditions:
- Dual Citizens at Birth: These individuals are exempt if they:
- Were born as dual citizens of the U.S. and another foreign country.
- Continue to hold citizenship in the other country and are taxed as residents there.
- Have not been U.S. tax residents for more than 10 of the past 15 years.
- Certain Minors: Individuals who relinquish U.S. citizenship before reaching age 18½ are exempt if:
- They have not been U.S. tax residents for more than 10 years prior to expatriation.
Who Is Not a Covered Expatriate?
An individual is not a covered expatriate if they do not meet any of the three tests under U.S. tax law when relinquishing U.S. citizenship or ending long-term resident status (green card), thereby avoiding the expatriation tax and related obligations.
To avoid being classified as a covered expatriate, one must fail all three tests: the Average Annual Net Income Tax Test, where the individual’s average annual net income tax liability over the last five years is below the threshold (about $190,000 in 2024); the Net Worth Test, where their total net worth, including all worldwide assets, is less than $2 million on the day of expatriation; and the Certification Test, where they certify on Form 8854 that they complied with all U.S. tax filing requirements and paid all taxes for the past five years.
Additionally, certain individuals qualify for specific exceptions and are automatically excluded from covered expatriate status, such as dual citizens at birth and minors who meet specific criteria.
